Editor's note: "Bricks and Mortar" is a series of columns written by real estate reporter Nicholas Yulico meant to help
readers generate real-estate-related stock ideas.
Investors looking to own
should keep an eye on rising construction costs in Macau. But the issue has been overblown, since Melco has so much attractive real estate it will eventually sell to offset these costs.
Melco, as a reminder, is a key casino stock in the "Bricks and Mortar" mock portfolio because the company is
well positioned to capitalize on the explosive growth in gambling in Macau, the only region of China where gambling is legalized.
Last year, total Macau gaming revenue rose 22% to $6.9 billion, which vaulted the area ahead of Las Vegas as the world's largest casino market.
Melco reported Friday that it lost $73.5 million in 2006, widening from its loss of $3.3 million in 2005. However, since the company's first casino is still not open, the loss numbers aren't particularly important. The only revenue coming in right now is from the company's Mocha Clubs, which are noncasino slot machine parlors.
Crown Macau, Melco's first casino, is set to open on May 9, management said on the company's conference call Friday. Melco recently announced a 14% increase in the total budget for the property. The additional $71 million of costs are mostly related to scope issues and marketing expenses, not rising construction costs, management said on the call.
One concern is that higher construction costs in China will force Melco to increase the $2.1 billion budget for its next casino property, City of Dreams, which is set to open in late 2008. The company's finalization of the design of the project "is occurring within a context of rising costs of construction, services and materials in Macau," Melco said.
Questions on the conference call focused on rising costs in Macau, and frankly, the company didn't do a great job of giving guidance on the possible ramifications. One of the largest owners of the stock told me the rising costs are not a big concern since Melco, like
Las Vegas Sands
, can monetize assets from real estate sales.
Melco is planning 600 condo units at its City of Dreams project, which will be located on the Cotai Strip -- the hotbed of development in Macau. Las Vegas Sands is building at least 3,000 condos at its master-planned developments on Cotai, centered around the Venetian Macau, which will open this summer.
"The Las Vegas experience has shown that consumers like the idea of having living spaces within close proximity to entertainment tourism options, and Asia's consumers would likely see Cotai-centric condos to provide that same value proposition," says Jonathan Galaviz, a partner with Globalysis Ltd., a boutique casino and lodging consultant that closely studies the Macau market.
Sheldon Adelson, the chief executive of Las Vegas Sands, is a master at explaining to analysts and investors the fact that his company is great at asset monetization. So when Las Vegas Sands announces construction cost issues in Macau, investors don't worry.
Melco's management could take a lesson from Adelson on this front. Melco's conference call was heavy on the cost side of the equation, but management didn't spend enough time focusing on the real estate side, which will be a very profitable piece of its business.
On the conference call, management was mum about possible increases in the City of Dreams costs, simply saying it anticipates some increase to the total budget at some point in time. Thus, investors should be prepared for future surprise announcements about cost overruns.
Admittedly, anyone buying Melco right now is gambling a bit, since there are no historical financials. However, the rewards for owning the stock will be hefty.
Melco should be able to grab at least $650 million of earnings before interest, taxes, depreciation and amortization in 2010.
Here's how I get that number. The large investor in the stock predicts that Macau's gaming revenue will grow to about $15 billion in 2010. By that year, or possibly in 2009, Melco is expected to have its three casinos fully up and running.
As one of just six operators in Macau, asking Melco to grab $2 billion of that revenue is not a stretch, the buy-side source says. Assuming a 25% margin, the company should have $500 million to $550 million of gaming EBITDA. Another $100 million of EBITDA will come from hotel and other nongaming profits.
If you also assume Melco can grab $1 billion to $1.5 billion of asset sales from condos and retail sites, that knocks down the stock's enterprise value.
Taking the midpoint, the enterprise value drops to $5.15 billion, down from $6.4 billion today. (Asset sales produce cash, which is not included in an enterprise value of a company.)
Discounting the future cash flows back to today, the stock today looks to be trading at a 9.5 times multiple on that future EBITDA stream.
That's way too cheap. Investors are paying 12 to 13 times EBITDA for Las Vegas casinos, and Macau is a much more profitable market.